Aflac's Hidden Source Of Value

In examining AFLAC's (NYSE:AFL) 10-K's from the last few years, I noticed that there seems to be some hidden value in this insurance stock.

AFLAC received $20.5 billion in premiums from customers in 2011. This is the float, or money that AFLAC holds on to, but may have to pay back in the future. It's an interest-free loan. In fact, it is a negative-interest loan because AFLAC can earn interest on it while they hold it. Additionally, the NPV of cash paid out in the future is much lower than the current value of the cash we receive. This is another spread that AFLAC can capitalize upon. The insurance company paid out less than $14 billion in benefits & claims for 2011. The $7 billion difference between the premiums collected and the claims paid is called an underwriting profit, and it is difficult to achieve. Basically, they got an interest-free loan for $20 billion but only had to pay back $14 billion, though they got to invest the entire $20 billion. Further, AFLAC received $3 billion in primarily low-risk investment income for 2011, so they borrowed money for free (technically, less-than-free, so I will re-phrase that). They were paid to borrow money that they didn't have to pay back and they invested the money in a profitable way. Or, they borrowed $20 billion with an interest-free loan, turned it into $23 billion, and paid back $14 billion of the loan.

Looking back over the past few years (including the recession), we can see that this has been an ongoing occurrence; they didn't just have one good year:

Year

Premiums Received

Claims Paid

Investment Income

2011

$20 billion

$14 billion

$3 billion

2010

$18 billion

$12 billion

$3 billion

2009

$17 billion

$11 billion

$3 billion

2008

$15 billion

$10 billion

$3 billion

Click to enlarge

You will note that there are two main sources of income. The first is the underwriting profit, or the difference between what they take in through premiums (the float) and what they pay out through claims. The second profit source is the investment income, which is the profit made by investing the float.

At first glance, it may appear that not much actual growth is occurring, as the underwriting profit is constant at around $6 billion per year and the investment income is constant at around $3 billion per year. However, during those four years, shareholder equity has doubled, from $14/share to $29/share. In addition to the prosperous shareholder equity growth, AFLAC shares its profits in an ever-increasing dividend payment to its shareholders. They pay you to invest in their stock, and they have increased that payment every year for 29 years. That rate of increase has outpaced inflation by 3-to-1.

One other unique aspect of AFLAC is that the investment portfolio is tilted towards low-risk investments. This is reflected in the stable investment income. By reducing risk, the investment portfolio maintains the liquidity and relative safety of cash while producing yield. This low-risk investment strategy will only yield greater returns in the future, should interest rates rise from their historic lows. AFLAC held over $100 billion in cash and investments at the end of 2011.

Lastly, when considering the balance sheet, liabilities have to be recorded at book value, but here book value does not accurately represent the economic value to the company. The entire float sits on the balance sheet as a liability, as claims they might have to pay out. However, it shouldn't be viewed as a liability, but rather as a revolving source of funding or an interest-free source of capital. Every month, policyholders deposit $1.7 billion in cash onto AFLAC's balance sheet with their monthly premiums, and this amount rises at about 13% per year as new policyholders are added.

The interest-free loan is AFLAC's advantage. As I write this, I am also thinking of ADP (NASDAQ:ADP), so I may take a future look at that company. They may have a similar situation, where they hold other people's cash. They take the withholdings from people's paychecks (even the paycheck itself), to be paid out at a later day (without interest). This includes taxes, benefit premiums, etc. They do this for 600,000 companies, which could mean 15 million paychecks every week. ADP is another topic, so I digress.

In conclusion, AFLAC appears to be a diamond in the rough with hidden sources of value. Moreover, the source of value is recorded as a liability, but should not be treated as such. While I do not make any recommendations to anyone, you may want to consider taking a second look at this company.

Disclosure: I am long AFL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.